So far, I think that I am the only commentator who has offered a theory of how credit default swaps create systemic risk. I'm not saying that I'm the only person with this theory, but I have only seen it described in my dialog with Will Wilkinson and my primer on systemic risk. The idea probably bears repeating.

A credit default swap is like insurance against default. If you want to buy a municipal bond or a corporate bond but not take default risk, you try to buy a credit default swap. You pay a fee, and in exchange for that fee the seller of the swap will make you whole if the city or corporation defaults.

The seller of swaps collects nice fees, and most of the time the borrowers don't default. But if borrowers do default, then the seller is like an insurance company in a town that was hit by a hurricane.

One strategy for people who sell swaps is to use dynamic hedging, the same approach that was notoriously used to provide portfolio insurance in 1987 and which helped cause the big stock market crash on October 19th of that year. With dynamic hedging, you create a synthetic put option by selling securities on the way down. If you sell fast enough, the money you make on the short sales is enough to offset the cost of making good on the swap.

Suppose I have sold a credit default swap on Sallie Mae. That means that if Sallie Mae defaults on its bonds, I will have to pay some of the bondholders a big chunk of money. One way I can hedge that risk is to sell short Sallie Mae securities. I can sell short their debt, or I can sell short their equity. The closer they are to default, the more I need to sell in order to execute the hedge. However, the more short-selling takes place, the closer they get to default. It is a vicious cycle. Ordinarily, I do not believe that short-selling affects the price, but when there is massive short-selling that is driven by dynamic hedging, I can see where the short selling would drive down prices.

So you could get a vicious cycle: doubts form about a company's soundness; creditors want more protection, so they try to buy credit default swaps; sellers of swaps engage in short-selling to hedge their own exposure; the company's stock and bond prices lose value; creditors get even more worried; etc.

At this point, if the government tries to curb short-selling, all that does is cripple the credit default swap market. It becomes costly to sell default swaps, so now creditors cannot get them at affordable prices. The only way they can reduce exposure is to sell their munis and their corporates and flee to Treasuries. I'm not saying that the curbs on short selling make things worse, but such regulations certainly don't solve the problem--at best, they shift it.

If my theory is correct, then the credit default swap protection is somewhat of a delusion. The contingency plans of individual sellers of swaps cannot be executed collectively. Just when you need to sell short in order to manage your risk, everybody else is trying to do the same thing, and it doesn't work.

It is too late to undo the delusion. In the aggregate, markets under-estimated the risk of the bonds they were buying. The risk premium needs to adjust upward. That upward adjustment is not a credit squeeze--it's a return to reality. Beyond that, there may a credit squeeze, because of the complex interaction among capital requirements, security valuation, investor psychology, and what have you. I don't envy regulators the task of sorting out necessary adjustments from needless panics. However, when in doubt, I lean toward assuming "necessary adjustment."

There are two types of errors that regulators can make. One type of error is to allow a good security to become undervalued or a solvent financial institution to fail. The other type of error is to over-pay for a bad security or to prop up an insolvent institution. The simple way to avoid errors in security valuation is to stay out of that business--don't execute the Paulson plan. As far as institutions are concerned, I think you have to give the FDIC and the Fed the latitude to make those calls, and hope they get as many of them correct as is humanly possible.

So, the current bailout bill is little more than the U.S. taxpayer providing a credit default swap (writ large) to a known impaired asset AND picking up the 'insurance' premium AND paying the premium by way of borrowing and incurring related interest costs!

Is there still anyone out there deluded enough to think the U.S. taxpayer is going to turn a profit on this?

Interesting. It seems that this vicious cycle could just as easily occur in the absence of CDSs if the creditors themselves engaged in dynamic hedging. Is the operative theory here that the sorts of firms selling CDSs are more likely to engage in dynamic trading than the original creditors are?

Secondly, there's a big question that you neglected to ask: Why doesn't anyone step in to buy these troubled stocks and bonds on the cheap when the vicious cycle starts to push the market price below their fundamental values? After all, it is precisely this countervailing force which ordinarily leads to the existence of an equilibrium market price. How does the stable equilibrium become unstable?

A "Swap" originated (I believe) as an exchange of two differing default exposures (not just one).
[Essentially - "I will swap you my risk for yours and pay you X points to do so."]

The terminology has been (wrongly?) expanded to include simple default insurances. Originally,MBIA was not in the "Swaps" business,that would have been the equivalent of a form of Reinsurance - and that is what Swaps have become by analogy.

The difficulties in differentiation create a difficulty in an "Options" type exchange, but do not prevent an active and effective "market."

If there is systemic risk (failure of the "insurance" aspect), one potential answer to explore is the application of the principles of Excess of Loss Reinsurance.

The Washington Post story mentioned that some of the sellers of CDS might not be able to come through if the insured bond goes into default.

If so, why is CDS considered such a valuable tool for limiting risk?

If I purchase 10 million of ABC corporate bonds and then purchase CDS for those bonds from Take-A-Risk Insurance Group in order to protect myself against the risk that ABC might default, I haven't really protected myself from risk if Take-A-Risk Insurance Group doesn't have the money to pay me for a potential default claim.

Sadly, the bailout passed today. I did do my part today by calling my congressman, Tom Price (R-GA). One of the many problems with the bailout is that it only treats the symptoms and not the underlying problem. In the interest of solving the underlying problem, what do you think about the idea of completely banning securitization of loans, period, eliminating the concept of LHFS (loans held for sale) as an aspect of a banks balance sheet. Then each bank would be more careful about the types of loans they underwrite because they would be permanently stuck with them. Practically, maybe it sounds crazy and workable. But as you are an economist, I'd like to hear what you think about it theoretically.

Arnold claims shorting (by CDS sellers) drives down stock prices. ("The closer they are to default, the more I need to sell in order to execute the hedge. However, the more short-selling takes place, the closer they get to default...I can see where the short selling would drive down prices."). Jacob Wintersmith doesn't buy it, because the existence of buyers leads to stable equilibrium prices in everything else, and presumably buyers exist for troubled bank stocks (at the right price).

It seems the latter point is right. Or at least it's not obvious what the causal relationship is between shorting and the stock price. That is, shorters lose when equity buyers are willing to pay more. If buyers aren't so willing, then the price is going to fall despite the shorting, not because of it.

With depository type institutions, the market action itself renders them insolvent. As the price of swaps rises and the stock price falls, depositors get fearful and start pulling funds. Without the panic induced by the swaps market and the subsequent fall in stock price, the institutions are healthy. If the original rise in the swaps price was produced by manipulation, then the entire episode is not based on fundamentals.

Bear. Lehman and Wachovia obviously made big mistakes in their investments and their stock prices should fall, but should they fall as far as they did? Generally, being a free market guy, I believe the market is always right, but in this case, I'm not sure.

Another point to consider: a lot of the fear in the MBS market was started by the fall in the Markit indices. These indices are also made up of illiquid secrurities suseceptible to manipulation.

I think a big part of the problem is that we had a lot of new products trading in illiquid markets.

TC makes an excellent point (and another is "why has the financial media done such a crappy job on this obviously HUGE story?"). I think the answer is that this is a way to hide & delay the apparent effects of inflation. It soaks up a lot of notional dollars which can later, when politically expedient, be dumped.

You can't really hedge CDSs by shorting stocks. In fact there is no way to hedge CDSs because it is necessary to DISCRETE default events. You cannot do this with a stock price which is continuous. Plus nobody really uses portfolio insurance anymore. Your story is not compelling.

"If borrowers do default, then the seller is like an insurance company in a town that was hit by a hurricane." Insurers protect against this possibility through reinsurance, which distributes risks over a broad base.

But are credit default swaps really insurance? Risks are insurable if and only if the law of large numbers enables the insurer to predict loss rates better than an individual. Insurance companies do not "hedge" losses, they pool them and price them. The comparable strategy for a firm seeking to insure against credit default is not to short the security but to hold all securities in the market.

Do you have a Private mortgage insurance (PMI) policy? If you do your PMI insurer has passed along their risk by buying a credit default swaps (CDS) to protect them in the event you have your home that your home is taken away from you. CDS and PMI are the same thing. Make people wanting to buy a home put at least 20% down if you don't like them. nomedals.blogspot.com

You need to consider an additional possibility: speculators are using credit default swaps as a way of betting against a company's creditworthiness. They buy swaps, but WITHOUT EVER OWNING THE UNDERLYING DEBT INSTRUMENT!

It works like this: a speculator BUYS credit default swaps, then sells short the stock of the company. If the companies' future is already cloudy and enough people are selling it short, it drives the price down, as you discuss.

Ratings agencies, noticing that the stock price is cratering, then downgrade the company. This downgrade doubles or triples the resale value of the credit default swap, because the bonds are perceived as riskier now. (The swap was originally sold when the bonds were perceived as safer.)

The credit default swap can then be sold for a huge profit. Or, if the speculator wants to hang in there for a really big payday, he can keep the swap and hope that bonds actually default. In this case he collects somewhere between 25 and 70 times his investment in the swap when the swap is paid off!

But this strategy is risky. The swap seller may not actually be able to pay. The speculator might lose his entire investment in the swap. So I suspect that in most cases the play ends at this point -- after the downgrade of the bonds, and after the swap is resold for a huge profit.

In this way speculators can systematically burn down companies and reap huge profits for themselves. They make money on the short sales, and they make money on the sale of the swap. If they get really lucky they actually get paid off on the swap, making 25 to 70 times their investment.

It's a pretty nifty scheme. The only downside is that you inadvertantly destroy the financial system and economy. Ooops!

But that doesn't really matter as long as you make lots of money for yourself. Screw the economy!

1) Here's a very good model of how synthetic derivatives can amplify a crash:
http://econpapers.repec.org/article/aeaaecrev/v_3A80_3Ay_3A1990_3Ai_3A5_3Ap_3A999-1021.htm

2) The CDS situation was particularly bad due the fact that they were all basically IOUs traded over the counter, with no organized clearing house. Have you noticed all the news about option and and futures contracts defaulting? No? That's because they have industry-wide clearinghouses and standardsized contracts.

yes and since it seems that CDS covering the loss associated with defaults account for 10% of the market, this means 90% of the market could be seen pure speculative betting. Akin to taking out life insurance against your neighbour.

therefore the potential swag is 900% of the default ammounts. so a bank defaults on 10Billion of loans there could be 9trillion of cds waiting to be paid out, if the 9:1 ratio of,lets call them phony:insurance swaps is equally distributed across all bonds and loans they are derived from default . Of course the ratios for one reason or another could and probably do differ. If there are indeed broad differences in these ratios then the cds whose numbers exceed the 9:1 average , all things being equal would be the ripest fruit.

as all things are not equal . The weakest would be the targets. It is perhaps worth noting the accusations made by the icelandic prime minister earlier this spring accusing bear sterns of attacking the currency and stock market , which would be in line with the scenario you describe.

perhaps there would be an additional dimension whereby as the cds price increases , institutions are tempted to make profit by writing identical cds contracts . increasing the payout when the default occurs.

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